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THE CIRCULAR FLOW OF INCOME

1he clrcular flow of lncome ls a !"#$"%&'$ macroeconomlc model. lL ls an alLernaLlve Lo Lhe neoclasslcal
model, whlch sees Lhe macro-economy as belng very slmllar Lo mlcroeconomlcs.

We sLarL wlLh Lhe slmplesL form of Lhe model, lmaglne l spend 30 on a chalr - leLs call Lhls "()"$*&+,-".
1hls expendlLure of 30 musL mean Lhe chalr ls worLh 30, so we can also say LhaL Lhe ouLpuL of Lhe
economy ls 30 because Lhe value of whaL ls boughL musL be Lhe value of whaL ls sold.















WhaL happens Lo Lhe 30 LhaL flrms recelve from selllng Lhelr ouLpuL? 1hey have Lo pay for Lhe land,
labour and caplLal Lhey use Lo produce lL, and lf Lhere ls anyLhlng lefL over Lhe enLrepreneur geLs a proflL
- so all of Lhe 30 ends up wlLh households one way or Lhe oLher. WhaL people earn ls Lhe same as Lhe
value of Lhelr ouLpuL, whlch ls Lhe same as Lhelr expendlLure - so now we can say LhaL Lhe value of
expendlLure, ouLpuL and &$./0" are all Lhe same. lf we measure Lhe economy by addlng up whaL people
earn lL should equal Lhe value of whaL reLall sales are, and Lhls should also be Lhe same as Lhe LoLal value
LhaL each flrm adds Lo a producL as lL goes Lhrough Lhe chaln of producLlon.

12" +4/5%".+/- 0/*"6

AnoLher way of demonsLraLlng Lhe clrcular flow
model ls wlLh a slmple Lwo-secLor model. 1he Lwo
secLors conslsL of households and flrms. Pouseholds
provlde Lo flrms Lhelr land, labour, caplLal and
enLerprlse and ln reLurn Lhey recelve renL, wages,
lnLeresL and proflL whlch LogeLher ls Lhe
households' lncome, leLs use Lhe leLLer ? Lo
represenL Lhls.

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1he Lwo-secLor model ls also seen ln a sllghLly
dlfferenL verslon. Agaln we have households and
flrms - households spend Lhelr money wlLh
flrms, whlch we call expendlLure and we use Lhe
leLLer L for Lhls. llrms glve renL, wages lnLeresL
and proflL Lo households - LogeLher Lhls ls Lhe
households' lncome and remember we use Lhe
leLLer ? for Lhls - we use ? because laLer we wlll
use Lhe leLLer l for someLhlng else. 1he goods
and servlces boughL by households ls Lhe ouLpuL
and we glve Lhls Lhe leLLer C. 1hls model ls
someLlmes known as Lhe spendLhrlfL model
because everyLhlng LhaL ls spenL ls spenL on consumpLlon goods or L = C.

ln Lhls model expendlLure and lncome are also equal, everyLhlng LhaL ls earned ls spenL, and because L ls
[usL Lhe LoLal of expendlLure we can [usL as reasonably call L '77-"7'+" *"0'$* - so we can say Au = L.
And as long as L and ? are equal, Lhe economy wlll sLay ln equlllbrlum and Lhere ls no pressure for lL Lo
grow or shrlnk.

Powever, Lhe Lwo-secLor model ls a poor represenLaLlon of how Lhlngs really are. We can make Lhe
model more reallsLlc by showlng LhaL some money leaks ouL of Lhe economy. When households earn
lncome Lhey don'L spend all of lL - some goes lnLo %'8&$7% accounLs or penslon funds. 1hese savlngs are
deposlLed lnLo Lhe flnanclal secLor, so we now have a Lhree-secLor model.

12" +2-""5%".+/- 0/*"6
















8ecause L no longer = ? we need Lo change Lhe model a llLLle, expendlLure ls replaced wlLh Lhe word
consumpLlon and we use Lhe leLLer C for Lhls. 8ecause consumpLlon ls less Lhan lncome Lhe economy wlll

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sLarL shrlnklng - flrms are geLLlng less and can'L pay Lhelr workers as much so ? shrlnks Loo -
LheoreLlcally lf people keep savlng, Lhelr lncome wlll keep on falllng Loo, and ln Lhe end Lhelr wlll be no
spendlng and no lncome and wlLh no lncome Lhelr wlll be no savlng elLher - Lhls slLuaLlon was named by
!ohn Maynard keynes as Lhe )'-'*/( /9 +2-&9+. 1he paradox ls LhaL lf )6'$$"* %'8&$7% are greaLer Lhan
lnvesLmenL Lhe economy shrlnks, and wlLh a shrunken economy, lncomes shrlnk Loo, whlch means LhaL
acLual savlngs wlll be much lower Lhan planned savlngs. keynes LhoughL LhaL savlng was a good Lhlng for
lndlvlduals Lo do, buL ln a recesslon lf everyone saved Lhe recesslon would conLlnue.

Powever, Lhe money saved ln flnanclal lnsLlLuLlons lsn'L [usL lefL Lhere, flrms borrow from Lhe banks and
penslon funds and lnvesL ln Lhelr buslnesses. lnvesLmenL ln economlcs means spendlng on caplLal goods
such as new machlnery, whlch ls noL Lhe same Lhlng as buylng sLocks and shares whlch ls [usL a form of
movlng money abouL.

When flrms lnvesL ln Lhe economy, Lhe economy expands and Lhere ls a correspondlng lncrease ln wages
and salarles, so lncomes lncrease, and because lncomes lncrease Lhen consumpLlon lncreases Loo.
Popefully you should see LhaL lf lnvesLmenL ls larger Lhan planned savlngs Lhe economy grows, and lf
planned savlng ls greaLer Lhan lnvesLmenL Lhe economy shrlnks. AL equlllbrlum where lnvesLmenL and
savlngs are equal Lhe economy ls sLable. We can now wrlLe an equaLlon Lo show LhaL aggregaLe demand
equals Lhe LoLal amounL of spendlng, Au = C + l.

12" 9/,-5%".+/- 0/*"6
Cf course Lhe Lhree-secLor model ls sLlll a llLLle slmpllsLlc. noL only do households save some of Lhelr
lncome -some of lL geLs used Lo pay Laxes.


















8y addlng a fourLh governmenL secLor we add anoLher layer of complexlLy. lf Laxes dlsappeared down a
black hole, Lhe economy would shrlnk, [usL as lL dld lf when savlngs were greaLer Lhan lnvesLmenL ln Lhe
Lhree-secLor model. Powever governmenL spendlng ls ln[ecLed lnLo Lhe economy [usL as lnvesLmenL was.

ln 1936 !ohn Maynard keynes (1888 - 1946) wroLe LhaL ln a depresslon lL was posslble LhaL planned
savlngs would exceed lnvesLmenL and Lhe economy would shrlnk and Lhls would resulL ln mass
unemploymenL. AlLhough Lhere mlghL be equlllbrlum ln Lhe goods and servlces markeL, Lhe labour

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markeL could be ln dlsequlllbrlum, where Lhe supply of labour was greaLer Lhan Lhe demand. keynes
blamed depresslons on a low level of aggregaLe demand. ln Lhls slLuaLlon flrms would lack confldence
and be unwllllng Lo lnvesL so Lhe problem would perslsL for a long Llme. 1he soluLlon Lo Lhe problem
would be for Lhe governmenL Lo lncrease spendlng above Lhe level of LaxaLlon. lncreased ln[ecLlons
would geL Lhe economy Lo grow. lf necessary, Lhe governmenL would have Lo borrow Lhe money Lo geL
Lhe labour markeL back lnLo equlllbrlum.

ln Lhe four-secLor model Lhe LoLal amounL of spendlng (aggregaLe demand) equals consumpLlon,
lnvesLmenL and governmenL spendlng. Au =C+l+C.

12" 9&8"5%".+/- /)"$ 0/*"6
So far our model has been a domesLlc model. 8y addlng a flfLh secLor we open Lhe model up Lo Lhe
world.

WlLh Lhe four-secLor model savlngs and Laxes leaked ouL of Lhe sysLem and lnLo Lhe flnanclal and
governmenL secLors, and Lhen were ln[ecLed back lnLo Lhe clrcular flow ln Lhe form of lnvesLmenL and
governmenL spendlng.

WlLh Lhe addlLlon of an overseas secLor money leaks ouL of Lhe sysLem enLlrely as money ls spenL on
lmporLs, for whlch we use Lhe leLLer M. AlLhough Lhe pounds LhaL flow ouL wlll evenLually flow back ln as
forelgners can'L do anyLhlng wlLh Lhese pounds oLher Lhan buy someLhlng from us, Lhey mlghL noL spend
Lhese pounds lmmedlaLely. So ln any Llme perlod Lhere ls no reason why money spenL on lmporLs should
equal LhaL earned from Lhe sale of exporLs (x.) 1hls compllcaLes our formula a llLLle because we musL
look aL Lhe spendlng on $"+ "()/-+% (x-M).

























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ln Lhls flnal flve-secLor model expendlLure (aggregaLe demand) ls made up of consumpLlon, lnvesLmenL,
governmenL spendlng and neL spendlng on exporLs. llnally we arrlve aL one of Lhe mosL lmporLanL
equaLlons ln economlcs.

:; < =>?>@>AB5CD
1he money LhaL flows ouL of Lhe clrcular flow ls called 6"'E'7"% or someLlmes wlLhdrawals (w).
lnvesLmenL, governmenL spendlng and exporLs are collecLlvely called &$F".+&/$% and Lhe small leLLer [ ls
someLlmes used. lf planned ln[ecLlons are larger Lhan planned wlLhdrawals Lhen Lhe economy grows, buL
lf planned wlLhdrawals are larger Lhan planned ln[ecLlons Lhe economy shrlnks. lf planned ln[ecLlons and
planned wlLhdrawals are Lhe same Lhen acLual ln[ecLlons and leakages wlll be equal Loo, and Lhe
economy nelLher grows nor shrlnks.

12" $"/.6'%%&.'6 "./$/0&. 0/*"6 8"-%,% +2" !"#$"%&'$ 0/*"6
neoclasslcal economlcs suggesLed LhaL Lhe macro-economy and Lhe mlcro-economy were allke. lf Lhere
was any unemploymenL Lhen Lhls was because Lhere was dlsequlllbrlum ln Lhe labour markeL. lf Lhere
were a surplus of labour, prlces would fall and Lhls would slgnal Lo flrms Lo hlre more people. WlLh
people now ln [obs Lhere would be enough money Lo buy everyLhlng LhaL was produced - so Lhe goods
markeL and Lhe labour markeL would always be ln equlllbrlum - or as Lhe lrench economlsL !ean-
8apLlsLe Say sald, Supply creaLes lLs own demand".

ln 1929 Lhe CreaL uepresslon, whlch had begun ln Lhe uSA, spread around Lhe world and Lhere was mass
unemploymenL almosL everywhere excepL ln communlsL sLaLes. !ohn Maynard keynes LhoughL LhaL Lhe
old neoclasslcal model had falled and he suggesLed anoLher way of Lhlnklng abouL macroeconomlcs. lL
was posslble for Lhe goods and servlces markeL Lo be ln equlllbrlum buL aL a level of demand LhaL
resulLed ln dlsequlllbrlum ln labour markeLs. Lven lf Lhe neoclasslcal model resulLed ln equlllbrlum ln
Lhe long run lL was no good keynes LhoughL because, ln Lhe long run we are all dead". Worse yeL was
Lhe LhreaL LhaL mass unemploymenL broughL pollLlcally. ln Cermany Adolf PlLler came Lo power parLly
on Lhe promlse of creaLlng full employmenL and elsewhere people were looklng also Lo fasclsm or
communlsm for answers. So for keynes lL was necessary for governmenLs Lo acL Lo save caplLallsm. ln
1936 ln hls mosL famous book, '1he Ceneral 1heory of LmploymenL lnLeresL and Money', keynes
suggesLed LhaL ln depresslons lL was a low level of '$&0'6 %)&-&+% LhaL caused a lack of aggregaLe demand
and unemploymenL. 1he answer was for governmenLs Lo borrow and spend.

!"# +"-0%

!"#$"%&'$ - economlc Lheorles based on Lhe ldeas of !ohn Maynard keynes.

G()"$*&+,-" - Lhe LoLal spenL on goods and servlces, whlch ls also Lhe same as aggregaLe demand.

?$./0" H Lhe renL, wages, lnLeresL and proflLs LhaL household earn.

:77-"7'+" *"0'$* - Lhe LoLal level of expendlLure ln Lhe economy C+l+C+(x-M).

I'8&$7% H lncome LhaL ls noL spenL.

:$&0'6 %)&-&+% - Lhe amounL of confldence people have ln Lhe economy, whlch effecLs Lhelr deslre Lo
spend and lnvesL or Lo save.

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